Nowhere to Hide…except Commodities
Renewed fears of inflation once again beset the stock and bond markets driving substantial losses during April and the first week of May. Higher inflation expectations were priced into markets driving bond yields materially higher and equity valuations significantly lower. The result was unusually high asset price declines and volatility. Meanwhile, commodities acted as a safe haven and performed well.
The Fed Futures curve (i.e., the yields on various short-term T-Bills) is a useful measure of the market’s expectations for interest rate hikes by the Fed. While the market expected and got a 50bps increase this month from the Fed, real action was further out the curve. For instance, at the beginning of April the market expected the Fed Funds rate to reach 2.5% by February 2023. By the end of the month, the market increased their expectations to 3.0%.
The key takeaway for investors is that the market is way ahead of the Fed in anticipating interest rate hikes. In other words, interest rates and, therefore, stocks and bonds are already pricing in significantly higher interest rates. The question is how high is high enough to bring inflation under control and not engineer a recession.
Fueling concerns and market volatility are two potential scenarios. The Fed fails to tighten enough to tame inflation and the economy goes into recession or the Fed tightens too much thereby choking off growth and the economy goes into recession. Whenever fear dominates market sentiment it is inevitable that prices eventually overshoot to the downside. (The opposite effect occurred last year when greed propelled markets to all-time highs.)
For months now, we have offered an alternative scenario and it is worth pulling out our recent Monthly Market Update presentation to see how we reach this conclusion. But, in short, we believe that the consumer is in great shape - employed and with high savings - and inflation may have peaked. We believe that a key driver of inflation has been extraordinarily high consumer spending on Durable Goods, such as cars, furniture and recreational vehicles. In March, Durable Goods spending was +35% higher than February 2020 (i.e., pre-Pandemic)[1]. This level is unsustainable in our view and once that spending declines so too should the associated inflation. Durable Goods have contributed approximately 30% of the increase in the Consumer Price Index[2]. Weakness in Durable Goods spending should then place downward pressure on overall inflation.
Our portfolio positioning has been defensive for some time as we expected volatility coming into 2022. It is hard for markets to rationalize GDP growth decelerating from the outrageous levels of 2021 in the face of record levels of inflation and rapidly rising interest rates. That is a recipe for volatility. But if we are not there yet, we believe inflation peaking is close and with that we believe a much more rational market for risk-taking could emerge.
Market Update
April was a terrible month for stocks across the globe and, particularly in the U.S. The S&P 500 fell -8.7% and the Nasdaq shed a stunning -13.2%. On a YTD basis, the S&P 500 is now down -12.9% and the Nasdaq has fallen -21.0%. Driving these losses were the concerns mentioned above but the relative moves driving the Nasdaq even lower is predominantly interest rate driven. So, in essence, the moves reflect a continuation of a theme that has played out for months: higher interest rates are bad for growth stocks. However, now economic growth concerns have crept into more value and cyclical stocks as well.
Fixed income continues to present a huge problem for investors, particularly conservative investors. The Bloomberg Barclays U.S. Aggregate Bond Index continued its downward trend falling -3.8% during April. This puts that index, which is customarily considered the core of any bond portfolio, down -9.5% YTD. In fact, the total return of this index is now zero over the last three years. The fact that even “safe” investments have not been safe is further aggravating market sentiment. To the extent that there is a bright side to this bond selloff, yields have risen to much more attractive levels for new money.
Commodities continued to rally providing the only real support for portfolios. The Bloomberg Commodity Index gained a further +4.1% in April putting it up +30.6% for the year. Natural gas continued to soar as the world grapples with replacing Russian supplies. The spot price on Henry Hub natural gas increased +28.4% and is now up over +94% YTD. On the agricultural front, corn prices increased +10.1% and are now up +37.9% for the year. From a structural perspective, we do not see any near term relief in sight for energy and agriculture commodity prices.
As of this writing, the sell-off in equity and bond markets has continued into May driven by all of the same reasons cited above. However, as April progressed, there have been a number of big down days and some indications of unusual stress. We would attribute much of that to the speed at which interest rates have risen. Therefore, we remain laser focused on upcoming economic data that could provide evidence that inflation has peaked. Peaking inflation, we believe, could provide an elixir for surging interest rates and, therefore, create a calmer investment environment.
Outlook
It is well understood that markets are forward looking and price in expectations for the future. Changes in asset prices occur as expectations change. For the last few months, the stock and bond markets have been pricing in higher interest rates to combat historically high inflation. The extreme level of inflation today has created a wider set of potential outcomes and, therefore, expectations that could be wildly incorrect.
For instance, the market is currently pricing in approximately 3% annual inflation into the US 10 Year Treasury bond yield. That expectation is well above the Fed’s 2% target. So, the market is essentially pricing in a scenario in which the Fed is unable to reign in inflation over the next ten years. Does this seem rational? To some it does and that is what makes a market.
Therein lies the most important driver of the direction of markets going forward: inflation expectations. Our expectation is that inflation will rollover somewhat over the next few months and that will enable markets to price in a less dire outlook. That, in turn, may provide the opportunity to become more bullish on both stocks and bonds.
Conclusion
Pullbacks can be anxiety-inducing in the short run. It is human nature to recall your highest account balance and compare it versus today. But we challenge you to look at pullbacks as opportunities like we do. Sudden changes in markets like we have recently experienced often create overcorrections. The proverbial pendulum often swings too far when the market has succumbed to fear (oversold) or greed (overbought). When we reach these levels – and we are getting close – some of the lowest risk, highest returns can be found. Given our tactical investment philosophy, we will likely be deploying capital and adding back risk as the inflation picture becomes clearer.
Disclosures
INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS OR INVESTMENT STRATEGIES. BLOOMBERG IS THE SOURCE OF MARKET DATA. INVESTMENTS INVOLVE RISK AND ARE NOT GUARANTEED. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RETURNS. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.